Today there are many proven manufacturing software solutions designed to meet the sophisticated needs of large manufacturing organizations. Unfortunately the price tag of these products often climbs to hundreds of thousands of dollars, if not millions of dollars. For this reason, these sophisticated products are virtually unaffordable to smaller manufacturing organizations. Nonetheless, smaller manufacturing concerns need accounting and system solutions to run their businesses, and today, many of these clever companies are able to meet a majority of their needs using entry level accounting software solutions, often supplemented with manual procedures, spreadsheet solutions, and third-party add-on applications. This report is designed to help smaller manufacturing organizations better understand those features and functionality within today’s top entry-level accounting systems that can help them run their manufacturing business.
According to the U. S. Bureau of Labor and Statistics, inadequate accounting systems are the second leading cause of business failure in the United States, (the leading cause of business failure is the inability to finance inventory). This misfortune applies to small and large companies alike. For example, in its’ 1999 annual report, Hershey’s acknowledged that a failed implementation of its’ accounting system [SAP] cost the company $463 million in profits. Other companies such as Enron, WorldCom, and Global Crossing have also garnered much attention for their own failings related to improper accounting. In much the same way that a poor accounting software system can put your company at a disadvantage, a superior accounting system offers many important advantages. For example, in the 1980’s Wal-Mart made an enormous commitment to implement the most effective and efficient accounting software systems known to the retail industry, and as a result Wal-Mart has grown to become the largest retailer in the world while competitors such as K-Mart, J. C. Penny’s and Federated Department stores have struggled to stay profitable. Although they may not grab national headlines, small companies suffer from the same fortunes, or misfortunes, as the case may be.
The importance of operating an effective accounting system is most applicable among manufacturing concerns. More than any other industry, manufacturers deal with many inventory issues concerning receipt, storage, tracking, assembly, and shipments. Additionally, manufacturing specific needs only compound their tasks and result in an even greater need for efficient and effective accounting. This report is designed to illustrate and discuss those prevalent accounting features that are most relevant to helping manufacturing concerns better manage and control their operations. We recommend that you use this report to help you identify accounting system features and functionality that will help you put your accounting software to work in your organization.
For companies that manufacture and handle inventory, it is most important to properly control and manage inventory. Presented below is a discussion of some of the core features found in today’s entry-level accounting systems that can help you best manage inventory and manufacturing materials.
One of the most common accounting software needs for inventory-based companies is “light manufacturing capabilities”. This functionality is also commonly referred to as “assembly”, “kitting”, and “bill of materials processing”. In essence the company combines multiple inventory items together to form a single inventory item for sale. The paragraphs below discuss these various forms of light manufacturing.
Assembly refers to the process of assembling an item as opposed to supply grouping items together. For example, consider the needs of a company that builds and sells carburetors. A single carburetor consists of many items as shown in figure 1. These individual items are referred to as components and would typically include items such as a carburetor bowl, two 4-gauge springs, 16 1/8th inch machine screws, 4 rubber hoses, etc. An accounting system that supports light manufacturing would allow the company to establish inventory item IDs for each of these components, as well as the completed item – the carburetor. In this manner, the accounting system allows the company to track all inventory on hand. As carburetors are assembled by workers, they simply indicate those assemblies as they occur with a quick entry to the system. The accounting system automatically increments the number of carburetors on hand by the number of built units, and depletes the appropriate number of components used in the assembly. For example, if 4 carburetors were assembled on Monday morning, the system would increment the number of carburetors on hand by 4, and deplete the number of carburetor bowls, springs, screws, and hoses on hand by 4, 8, 64, and 16 respectively. In this example, the worker has assembled an item using other inventory items, and in this case, the term “assembly” is typically used to refer to this process.
In a different example, consider the needs of a company that sells medical supplies. Such a company would maintain vast shelves of medical supply items, each of which might be sold individually or as part of a kit. Typical medical supplies might include adhesive tape, gauze bandages, antibiotic cream, aspirin, thermometers, splints, blood pressure monitors, hypodermic needles, stethoscopes, stretchers, etc. These items may be priced separately or combined in different assortments to produce various first aid kits suitable for homes, businesses, recreational parks, or even emergency technicians. To build a special kit, a worker gathers the appropriate items and packs them together to create the first aid kits. While the process of packing various medical supplies into a container is different from the assembly of a carburetor (as described above), from an accounting perspective the system accounts for this activity in virtually the same way. As kits are completed, the system would increment the number of kits on hand by the appropriate number of units, and deplete the various components on hand by the appropriate number of units. While the kitting routine converts quantities of individual items to completed units, it is also rolls up the costs associated with each component item into the total cost of the first aid kit.
The processes we have described above are often referred to as “assembly” or “kitting”, but are also referred to as bill of materials processing, or light manufacturing. To an extent, these terms are used interchangeably throughout the accounting software industry. An understanding of this feature is extremely beneficial to manufacturing companies when it comes to using entry-level accounting systems to account for manufactured items.
Accounting for Labor
At this point, many manufacturers would agree with the benefits of the assembly functionality, but may raise an issue associated with accounting for labor costs and factory worker wages. As it turns out, this is not a problem at all. Small manufacturing companies can employ clever techniques for capturing and accounting for this important information. Many entry-level accounting systems allow for the establishment of a labor item in the inventory system. Once established, the labor item can be included in “assemblies” or “kits” in the same way that regular inventory items are included. To better understand this concept, consider the following example:
A customer experiences an automobile accident, and fortunately they are uninjured. They take their automobile into the shop for repair. The auto repair shop repairs the automobile, billing the customer for both time and materials used on the job (one fender $250, one bumper $350, and 8.25 repair hours at $40 each). How do they do it? Simple. The auto repair company has set up an inventory item called a repair hour which the company sells for $40 each. The company could also set up painting hours for $50 each, cleaning hours for $12.50 each, and engine steaming hours at $30 each. Many entry-level accounting systems are designed to properly accommodate these labor items which means that sales tax is not calculated on these labor items and quantities on hand are not considered in selling these items to a customer. The result is that from an accounting software perspective, the customer purchased one fender, one bumper, and 8.25 repair hours, and the customer’s sales invoice reads perfectly, complete with the appropriate sales tax calculations.
In much the same way that the auto repair shop charged the customer for labor time, manufacturers can set up labor items and then include them in the “assembly” or “kitting” process. The result is that the assembly or kitting process captures both time and materials for costing and sales pricing purposes. For example a basic first aid kit may include the following items: “Flash light ($3.00); band aides ($1.20); antiseptic spray ($2.20); ointment ($3.35); and .15 assembly hours ($1.50). In order to utilize this feature in this manner, manufacturers must identify each labor task performed during the light manufacturing process. For example, the manufacturing of a twelve dozen flags may involve 1.2 cutting hours, 2.4 sewing hours, .4 assembly hours, .1 inspection hours, and .2 packaging hours. In this example the company would need to set up 5 different labor items to reflect these 5 activities. Each activity could be priced separately. For purposes of light manufacturing, the manufacturer would most likely use a standard length of time for each activity, even if the actual activity varied from job to job. Even the largest of organizations find it beneficial to adhere to standard times rather than actual times for the purposes of consistency and convenience.
Standard Costing Versus Actual Costs
In some cases, manufacturers may wish to track and bill the actual time incurred during the manufacturing process. This too can be accomplished with entry-level accounting systems. In order to make this happen, the manufacturer must set up the sales order as a job. For example, an order to manufacture and deliver twelve dozen flags could be entered into the system as a job, complete with estimated costs and budgets by phase and line item. Thereafter, actual materials used in the job are depleted from inventory and introduced into the manufacturing process as part of that particular job. Similarly, time expended during the manufacturing process could be entered into the accounting system, and booked to that job. Upon completion, the accounting system’s job costing module would produce a job cost report complete with detailed listing of all materials used and all time incurred in the completion of that job. Far from being a stretch, this is exactly how many larger manufacturing organizations keep track of their “made to order” and “engineered to order” activities. In manufacturing circles, these companies are known as “Job Shop Manufacturers”.
Multiple Levels of Bills Materials
Compounding the concept of light manufacturing further is the need to include assembled items or kits in bigger items or kits. Consider, in our example above, we described the assembly of a carburetor – a process that is easily handled by top entry-level accounting systems. Likewise the assemblies of a front tire, rear tire, frame, and even an engine can be handled by many of today’s entry-level accounting systems. A manufacturer might refer to these items as sub-assemblies. Once all of the sub-assemblies are completed, they are then assembled together to produce the final product which is a motorcycle. In order to accomplish this task, the accounting system would need to allow the manufacturer to include assembled items in other assembled items – a concept with is commonly referred to as multi-level bill of materials processing. Today, many top entry-level products support this capability and the clever manufacturer can take advantage of this functionality simply by methodically breaking down the assembly process into small sub-assemblies that match the company’s manufacturing process.
Invoicing Assembled Items
Once a manufacturer has assembled an item for sale, today’s top entry-level products often offer the option to invoice that item with either a summary or detailed invoice. In the case of a first aid kit, the manufacturer may prefer to provide the customer with an invoice that prices the first aid kit, but lists the components of the first aid kit on the face of the invoice. In the case of a manufactured motorcycle, the manufacturer would most likely suppress the detailed list of components from the invoice, opting instead to include a single line item identifying the motorcycle.
Back Orders and Dis-Assemblies
In a perfect world, the procedures described above would all work well. However, real world situations tend to tax your accounting system in ways that you may not perceive at first glance. For example, assume that you have five carburetors on hand, and you suddenly receive an order for 25 carburetors. In this case, you know that you are short of the necessary carburetors and that you will need to build some more units. However, you have the added complexity in that you now need your system to advise you as to the number of various carburetor components you have on hand, and the number you need to complete the order. This information is necessary to order the appropriate number of needed components from your suppliers. For example, you may have an adequate number of carburetor bowls, tubes, and springs on hand to build the necessary units, but you may be short of the necessary screws, gaskets, and housing fixtures. Rather than running out to the warehouse to hand count each component comprising a carburetor, your system needs to provide you a report detailing the needed items. While most entry-level accounting systems do not produce automatic back orders on the fly, there are work-around procedures that can accommodate the process in a pinch. For example, the manufacturer could tell the system that they have assembled the necessary 20 additional carburetors needed (even though these units have not actually been assembled). This process would force the system to deplete the various carburetor components by the appropriate amounts. Thereafter, the manufacturer could produce an inventory report which details each component of the carburetor assembly and the number of units on hand. Those units with negative balances on hand indicate the minimum number of units that must be reordered to manufacture the remaining carburetors. Once this report is prepared, the manufacturer could then dis-assemble the 20 carburetors so that the system once again reflects reality. While this process may not seem exquisite, it is a process that can and does work for thousands of manufacturers who run their businesses on entry-level accounting software products. Similar results could also be obtained by exporting inventory reports to Excel and using formulas to calculate the necessary quantities of items to be ordered.
Along similar lines, what would happen in the event that a manufacturer suddenly sells more individual components than on-hand? For example, in our medical supply operation described above, let us assume that we have built five first aid kits and we have received an order for five rolls of adhesive tape – but our shelves are empty. In this case the manufacturer may disassemble some of the first aid kits to dig out the adhesive tape. While this process may seem arcane, in the real world situations like this do occur and when they do, your inventory system should be able to track the quantities and costs appropriately. This process would be the reverse of an assembly and would reduce quantities of first aid kits and increase the units in the individual components.
As we have learned, assemblies are a powerful feature found in many inventory management systems. We’ve seen how job shop manufacturers can use assembly features combined with job costing capabilities to meet the needs of discrete manufacturer concerns. At the other end of the spectrum is process manufacturing. In most circles, process manufacturing is considered to be even more difficult to account for than discrete manufacturing. This is because process manufacturing depends upon “formulas” or “recipes” in order to complete the manufacturing process. In our carburetor example used above, there is always one carburetor bowl used to construct each carburetor. However in a process manufacturing environment, the amount of potatoes used to make potato salad will fluctuate depending upon the amount of potato salad being produced. In fact, all of the ingredients will fluctuate depending upon the total amount being produced. This added complexity makes process manufacturing more difficult to account for. Still, small manufacturers use entry-level accounting systems to do just that. By using the “assembly” and “job costing” and “time and billing” concepts described above, they are able to create recipes as “assembled items” – and then adjust those items by building fractions of assembled items. As a tip, rather than using complex English measurements such as pints, quarts, gallons, and pounds, this process is far easier when the metric system is used to account for quantities on hand. In this manner adjusting the total quantity of item to be manufactured, is as simple as moving the decimal point. For example, let us assume that management has decided to produce 1,000 liters of cole slaw instead of 100 liters as the normal recipe (assembly) calls for. In this case, management indicates that 10 units of cole slaw are to be produced, and the ingredients for producing the larger batch of cole slaw are automatically adjusted by the system. Likewise, a decision to produce just 50 liters of cole slaw could be accomplished by producing just half (.5) of unit of cole slaw. This process automatically adjusts the components needed by the appropriate amounts and process manufacturing is more easily accomplished in an entry-level environment.
Bar Code Readers & Scanners
The use of bar code readers and scanners has increased dramatically in recent years, particularly within the retail environment. However the cost of hand-held bar code devices have dropped considerably and it is now common to see bar code readers in use in virtually any environment that involves the handling of inventory – including manufacturing situations. Smaller manufacturers are sometimes intimidated by the prospects of implementing bar code readers in their organization, but closer inspection suggests that these concerns are unwarranted. Bar code readers are relatively easy to install and they can be easily integrated with any entry-level accounting system. To help you better understand how bar code readers function, consider this example:
As you are well aware, your computer has a keyboard that allows you to type in an inventory number into the accounting system. With most bar code readers, this arrangement does not change. What does change is that a “wedge” is plugged into the computer’s keyboard port, and then the computer’s keyboard is plugged into the wedge. Thereafter, the data entry clerk has the option of either typing in the inventory number into the system via the keyboard, or scanning a bar code label which is read by the bar code reader, compared to a database of bar code labels, the label is associated with the appropriate inventory number, and that number is entered into the system for you. Because the bar code reader can actually perform this process much faster with greater accuracy, most data entry clerks use the bar code reader rather than entering the inventory ID manually. As we have all experienced many times at our grocery stores, in some cases a product’s bar code label is damaged and the order entry clerk must resort to entering the inventory ID manually. In this example we see that because the bar code reader is simply a device that enters a number, it really does not matter which accounting system you use – most bar code reader devices work at the keyboard level.
While bar code readers can be rather simple to implement, there are several important facets that must be considered as follows:
With these concepts in mind, small manufacturers should consider the benefits of implementing a bar code system within their organization. Bar code readers are useful in recording the receipt of inventory in the warehouse, the removal of inventory from the shelf, the progress of inventory as it travels through the cells (workstations) of a manufacturing process, or at the cash register as goods are sold. Once bar code systems are properly implemented, many small manufacturers report that these systems pay for themselves through increased efficiency and accuracy.
Without exception, flexible pricing is the most important feature related to the manufacturing and sale of inventory. In the real world, most small manufacturers have a strong need to price their inventory at different levels depending upon the customer involved, size of the order, time of year, and other factors. Many entry-level accounting systems provide flexible pricing capabilities, the most basic of which is the ability to assign multiple sales prices to a single item. For example, a small manufacturer may sell a 3 million candlepower flashlight for $45.99, $41.99, $35.50, or $ 32.00 depending on whether the customer is a walk-in customer, regular customer, government contract customer, or preferred customer, respectively. This practice is known as tiered pricing and is a common practice that reflects the inherent economics of supply and demand. Consider:
A walk-in customer may be a stranger as opposed to an established customer. Accepting a check or credit card from this on-time customer may bear a higher risk of bad payments, and thus justify the higher sales price. Additionally, the merchant typically incurs a higher carrying cost associated with stock inventory that may have been sitting on the shelf for several months awaiting purchase. A regular customer with established credit is probably less of a risk and may be worth extending a favorable price to ensure loyalty. In the case of a government contract, there may be a pre-negotiated set price that the small manufacturer must honor for a specified period of time. Finally, a preferred customer may order in larger quantities with plenty of lead time and flexible delivery, allowing the small manufacturer to obtain the necessary goods and deliver the finished product with minimal carrying costs. All of these examples illustrate why support for multiple price levels is often needed.
Another common pricing feature that is frequently requested by small manufacturers is quantity break pricing. For example a manufacturer may sell golf balls for $2.00 each, $1.75 if the customer purchases a dozen, and $1.50 each for purchases of twelve dozen or more. At first glance, many entry-level accounting systems appear not to offer quantity break pricing – but a simple work-around procedure makes it relatively easy to achieve. The company need only set up three inventory items representing a golf ball, a dozen golf balls, and a gross of golf balls. The latter two items could even be set up as assembled items. The individual golf balls would be priced at $2.00 each, the set of one dozen balls would be priced at $21.00 ($1.75 times 12), and the gross of gold balls would be priced at $216.00 ($1.50 times 144). As customers purchase the golf balls in differing quantities, the sales clerk need only ring up the appropriate inventory item in order to extend quantity break pricing. Notice also that in this example, it is still possible to assign multiple price levels to each item, so that walk-in, regular, government, and preferred customers could still receive both tiered pricing and quantity break pricing, which is commonly referred to as matrix pricing.
These same principles can also be applied in the manufacturing process. Assume for example that a small manufacturer builds custom bird feeders. In this case, the raw materials introduced into the manufacturing process could be priced differently depending upon the type of customer submitting the order (regular, government contract, or preferred for example) and the pricing could also reflect breaks for larger quantities as well.
It should be noted that an important pricing concept involves the ability to assign customers to different pricing categories. For example, Mr. Johnson may be categorized as a regular customer; the City of Townsville may be categorized as a government contract customer; and Mrs. Thompson may be categorized as a preferred customer. Thereafter, most top entry-level accounting systems automatically extend the proper price levels to each customer according to their defined customer type.
To appreciate this functionality, try for a moment to imagine an order entry clerk trying to keep track of the correct pricing for hundreds of customers. In this context, it is easy to understand how difficult this might be for a mere store clerk and why it is important for the system to track customers by customer type. These pricing strategies explained above are very effective at helping small manufacturers charge the right price to the right customer for the right orders. The results are that manufacturers can use different price levels to maximize profits and for their preferred pricing customers, yield higher customer satisfaction.
“Description Only” Items
Small manufacturers in particular have extraordinary needs to include verbose product descriptions on the customer invoice. Many accounting systems do not provide adequate room for companies to completely and properly describe the products they sell. For example, let us assume that a company has manufactured a 21-gear bicycle, with extra heavy duty front and rear shocks, custom painting, custom luggage rack and saddle bags. Many accounting systems allow only 32 to 64 characters to describe a product, leaving the manufacturer with the inability to accommodate the detailed description. In this case, the company would prefer to present the customer with a detail invoice that fully describes the product for both the customer’s benefit as well as for internal purposes (i.e. capturing such information may be useful for warranty or insurance purposes.)
While many entry-level accounting systems fall short in this area, this problem can often be overcome by simply creating a few “description-only” inventory items. For example, item number 1001 could describe the basic bicycle, while “description-only” items 1002, 1003, and 1004 could describe the front and rear shocks, custom painting, custom luggage rack and saddle bags, respectively. In this case, the description only items can be set up with zero cost and zero price so they don’t actually affect inventory valuation or the total cost of the bicycle. Instead, the customer receives an invoice for all 4 items total – the bicycle (priced at $400) and the three added descriptions (priced at $0 each). From the customer’s perspective, the invoice reads perfectly, describing the item in detail. This also ensures that the detailed information is properly captured in the accounting system as well.
Many entry-level accounting systems will allow for virtually an unlimited number of “description only” items. These descriptions could then be used as part of an assembled item to group descriptions together with other inventory items. For example, a manufactured chain saw might be assembled together with two separate “description-only items” that read “always wear safety goggles when operating this chain saw” and “add oil to the crank case before starting or you will damage the engine”. Once again, the customer invoice reads perfectly. It is creative uses such as this that allow small manufacturers to maximize the utility of entry-level accounting software packages to meet their sophisticated needs.
Event Triggers & Managing By Exception
In an ideal world, manufacturers would have controllers and CPAs on staff constantly monitoring key financial numbers such as cash-on-hand, profit percentages, gross profit margins, quantities-on-hand, etc. Unfortunately few companies have the resources to dedicate personnel exclusively for this task. In most cases, the labor costs are too high. Even the best run organizations monitor these critical factors on a monthly, rather than continual basis. This is where your accounting system can help. Some entry-level accounting software products offer the built-in ability to alert users to financial conditions in the event that they exceed predefined parameters. This feature is often called “event triggered reporting” in accounting software terms and is also referred to as “managing by exception” in managerial terms. To use this feature, manufacturers can create calculations that the accounting software continuously compares against preset values. When a preset value is exceeded, an alert pops up on the computer screen, or is e-mailed to the appropriate recipients, warning that a preset condition has been exceeded. For example, a CFO might set up the following event triggered reports to issue warnings or announcements in the event that the following conditions are met:
In all of these events, the triggered reports would prompt management to take the appropriate actions such as calling the bank to arrange for a working capital loan; increasing prices or controlling purchasing costs to generate higher gross margins; investigating payroll records to determine if an employee has been improperly overpaid; sending a memo to the sales team congratulating them on achieving an important milestone; reordering compressors to ensure that an adequate number remain on hand; devoting more resources to accounts receivable in an effort to collect outstanding debts more timely. In most cases, there is no limit to the number of triggers that can be established.
Not only are event-trigger reports good tools for monitoring the health and financial condition of a business, but used appropriately, this feature can have a dramatic impact on the company’s success. Consider the following example in which event-triggered reports are used to help a small manufacturer remain connected to all members of the supply chain:
A furniture manufacturer produces a dining table using rare materials harvested from the teak forests of Thailand. It typically takes longer to receive the teak wood materials than all other components. In this case, the company could set up an event triggered alert to monitor the levels of various teak wood materials on hand. Thereafter as teak wood is pulled from inventory and used in the production process, declining inventory levels would automatically alert the company’s purchasing agent of the this condition, and could also e-mail the supplier directly placing the appropriate order for additional teak wood material.
These “alerts” or “event-triggered reports” may be used to communicate with persons inside as well as outside the company. For example the system could be set up to automatically notify a customer when they are close to exceeding their credit limit, or when their outstanding account balance exceeds 45 days. With a little imagination, small manufacturers can put event-triggered reports to work to help them make better decisions in a more-timely manner.
Even large manufacturers are crippled if they are unable to obtain the materials needed for the manufacturing and production process. Most entry-level accounting packages can be used to help avoid inventory shortages in a variety of ways. By automating the purchase order process, small manufacturers can also minimize carrying costs.
The first step in the procurement process is to identify the necessary items to order and determine the desired order quantities. Proper tracking of inventory quantities on hand, reorder points, and order lead time is mandatory for deciding which items to order. Your accounting system should enable you to quickly determine the number units on hand (items in stock) as well as the units available for sale (defined as the items in stock plus items on purchase orders less items on sales orders). This information should be stored for each inventory item and available both in printed reports and for export to Excel.
What happens if you place an order for a specific item from your supplier and discover that it is not available or will have a delayed shipping date? You need to be able to find an alternate source for the item in order to meet your customer’s planned delivery date. Your inventory system can come to the rescue again when you store information about alternate suppliers for critical inventory items.
Once the items have been identified, the next step is to create a purchase order. Many manufacturers order the same materials from the same suppliers on a regular basis. Rather than having to re-enter the purchase order information each time, a more efficient approach would be to open previous purchase orders and make changes to units ordered as needed. In some entry-level systems, blanket purchase orders can be created for a single supplier, while others allow you to copy key information from one purchase order to the next. Either technique reduces the data entry time.
Inventory Valuation Methods
In small manufacturing environments, it is sometimes important for companies to employ differing inventory valuation methods to properly account for the raw materials consumed. In periods of rising or declining inflation, the costing method selected can have dramatic impact on the resulting profitability of the company. For example, PC manufacturers operate in an environment where raw material costs are declining almost daily. In this case, the LIFO method of accounting for inventory would result in a lower cost of goods sold, thus increasing reported profits. In other industries where costs are increasing, the FIFO costing method may produce the lower cost of goods sold, and thus higher profits. For this reason, small manufacturers should evaluate the market for their raw materials and select the most appropriate inventory costing method to produce maximum profits, or minimum taxes, whatever the case may be. Many entry-level accounting software packages accommodate multiple inventory valuation methods for these purposes.
In other cases, increased profitability or minimized taxes may not be as important as stabilized inventory costing in environments where raw materials costs fluctuate widely. In this case the weighted average method of costing may be most appropriate. For example, let us assume that a small manufacturer consumes a great deal of plywood in the manufacturing process. As hurricanes threaten the eastern seaboard, the demand for plywood sky rockets and the cost of plywood can climb dramatically, virtually overnight. Once the hurricane turns and heads out to sea, demand for plywood drops instantly, and a glut of plywood that had been shipped to the eastern seaboard now represents an over supply, and the cost of plywood falls dramatically. Such wide swings in costs can play havoc with a small manufacturer’s attempts to measure the profit margins. For example, the construction of 125 storage sheds in one week may produce a profit margin of just 12%, while the construction of 125 identical storage sheds in the following week produces profit margins of 48%. These conditions make it difficult for management to monitor all of the relevant factors associated with profitability such as work crew efficiency and the costs of other components. By using the weighted average method of valuating inventory, the company minimizes the impact of wide swings in plywood pricing, and the resulting measurements are more comparable from week to week, allowing management to better evaluate production.
Monitoring Business Health
The fundamental purpose of any accounting system is to “summarize transactional detailed data into financial reports that management can use to run the business”. Most accounting systems do an excellent job at producing a wide variety of reports to be used to this end, however many smaller companies fail to take full advantage of these reports, on average producing and reviewing fewer than 10% of the reports that the system is capable of producing. Small manufacturers can gain valuable insights and make better decisions by tapping into the business data contained within the standard reports, as well as customized reports. A manufacturing company, like every other viable business, must remain firmly focused on financial information – not just the Income Statement and Balance Sheets, but also other critical indicators such as receivables and payables aging, working capital ratios, inventory turnover, customer trends, budget-to-actual comparisons, estimate-to-actual comparisons, time and expense summaries, inventory reorder worksheets, back order reports, and more.
In order for these indicators to be most useful, they should be available on a real- time basis and be readily accessible to all pertinent parties. Most entry-level accounting systems produce an abundance of financial and managerial reports, but they are only useful when management personnel actually produce these reports regularly and are well-trained in reading and understanding the content these reports contain. Additionally, some entry-level accounting systems provide the ability for remote users to gain access to the system reports through password protected access via the Internet. In this manner, remote users such as traveling sale representatives, purchase agents, or mangers located at different locations can gain access to secure information in order to better manage the business. Additionally, a simple review of the bottom-line results do not go far enough; business managers must be able to easily examine the supporting details by drilling down into the underlying transactions. If information is hard to find or requires too much effort on the part of a manager, it will not be used. At a minimum the following key business indicators should be available to a small business at all times:
Cash Position - A company’s cash position (cash on hand plus expected collections minus expected payments) is one measure that every small business owner should be following on a daily basis. Inventory is a critical component of cost management and has an immediate impact on cash flow. If sufficient quantities of critical manufacturing components are routinely unavailable, one of two situations will result – sales will decline due to delays in customer service or profitability will decline as rush orders are placed for missing components. Both of these scenarios will impact profitability and cash flow. Monitoring the cash position of a manufacturing organization on a frequent basis is therefore a good way to determine if inventory is being effectively managed.
Inventory Turnover – The inventory turnover ratio is computed by dividing the cost of sales by inventory value. The resulting product tells how many times inventory turns over in a given year. By dividing the inventory turn over, you can determine how many days supply of inventory you have on hand. By monitoring this measure continuously over a period of months or years, managers can assess whether they have too much, or too little inventory on hand at any given point in time. For example, let us assume that a small manufacturer of vases has purchased $500,000 in plaster this year, and currently has $25,000 worth of plaster on hand. In this case, the inventory turnover is 20 ($500,000 divided by $25,000) and the company currently has enough plaster on hand to meet their needs for 18.25 days (365 days a year divided by 20 turns). If the manager knows that the company typically carries a 24 day supply of plaster, then this measurement suggests that it may be time to place an order for additional plaster. If other manufacturers of similar size typically carry a 10 day supply of plaster, then this measurement suggests that the company may be carrying more plaster than is necessary – which of course drives up interest expense, carrying costs, risk of theft or damage to the plaster, etc. For these reasons, it is important for small manufacturers to monitor the days in inventory for all critical materials at all times.
Days Receivables Outstanding – The days in receivables calculation represents the average time it takes to collect payment on invoices. The calculation equals the total balance in accounts receivable times 365 days divided by the annual revenue. The lower the number of days, the better the company is in collecting its sales in cash. By monitoring this measurement over months or years, management can easily see whether customer payments are coming in at a normal manner or that a collections problem may be brewing in time to take corrective measures.
Supply Chain Solutions
Supply chain solutions are now well-proven and readily available to virtually all companies, and small manufacturers will reap the most benefits. In recent years supply chain automation has grown steadily throughout the United States as well as the rest of the world. Manufacturers who fail to embrace supply chain technologies ultimately may be left behind. Perhaps one of the best illustrations of the benefits of supply chain automation is seen in the following example involving Wal-Mart.
In the early eighties, Wal-Mart placed heavy emphasis on developing and implementing tight supply chain solutions which has catapulted them not only to the top of the retail channel – but into the history books. Here is how it works. Let us assume that you purchase a flashlight at Wal-Mart. The cash register reads the bar code price tag and reportedly within fourteen seconds, the Wal-Mart central warehouse is notified that the Wal-Mart retail store needs a new flashlight for the shelf to replenish the purchased item. Further, the manufacturer is also notified that the Wal-Mart central warehouse needs a new flashlight. Even the raw material suppliers are notified that the manufacturer now needs a little more raw materials (plastic housing, switch, light bulb, etc), and so it goes – all the way up the supply chain.
Wal-Mart’s supply chain technology has allowed them to break the three-day barrier that some economists in the eighties felt was largely unbreakable. In other words, Wal-Mart is often able to replenish items on the Wal-Mart shelf in less than three days – not from the central warehouse to the shelf, but from the manufacturer to the shelf. With quick and reliable 2-day turn around, Wal-Mart is able to maintain lower levels of inventory and still meet customer demand. These lower inventory levels result in either a reduced floor plan with lower carrying costs and lower interest expense – or a greater diversity of products on the store shelves. (i.e.: With faster replenishment, Wal-Mart can get away with carrying just 5 toasters instead of 10, thereby freeing up more shelf space for those George Foreman Hamburger cookers.)
Additionally, because Wal-Mart is better able to order inventory on demand, the company is in a better position to meet customer demand. Today’s fads (pet rocks, crazy bones, Pokemon cards, etc) are tomorrow’s obsolete inventory. Wal-Mart’s superior supply chain technology allows the company to help avoid carrying an oversupply of fad items. Consider that just twenty years ago, J C Penny’s was ordering goods 90 days ahead of arrival, making the ordering process mostly guess work trying to determine if a particular leisure suit would still be in style by the time it hit the shelves three months later. This was such a big problem that an entire industry emerged to address this problem. Companies such as T. J. Max emerged to take obsolete inventory off the hands of companies that over-ordered and move it through deeply discounted outlets.
The same supply chain technology enjoyed by Wal-Mart is now relatively affordable to companies of all sizes. From supplier to producer to customer, the more communication and coordination that is available, the lower the costs and the higher the net profits will be. There is no better vehicle for providing visibility throughout the supply chain than remote access via the web. Today, some top entry-level accounting products provide web-based access to their accounting systems. Among other benefits, this allows customers to access their account information to check the status of their orders, and identify the customer representatives associated with those orders. Likewise, vendors may access the status of purchase orders and inventory levels – all via secure, password protected, data-encrypted access. With this immediate access to information, decisions can be made faster up and down the supply chain, thereby keeping rush shipments, special orders and other costly exceptions to a minimum.
Today’s entry-level accounting systems are more powerful than ever before. Small manufacturers who understand how to put these advanced features to work can use them to their advantage. An accounting system is the lifeblood of an organization and nowhere is this truer than in a manufacturing environment. There are many tools and methods that will enable a diligent company to maximize profits, control inventory, improve customer service, and streamline operations. Small manufacturers would be well served to invest the proper amount of time and expense to implement these features to their benefit.
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